Project returns drop on average 250 basis points (bps) over their investment lifecycles. Here’s why.
Despite the $10 trillion of new investment expected within the renewable energy industry over the next 20 years, asset managers are facing three factors that are putting their profits at risk:
- Rapidly Decreasing Power Purchase Prices
Declines in technology and installation costs, paired with abundant supply have brought energy pricing to unprecedented lows, as low as $0.0177 per kilowatt hour (KWh) in some regions.
- Significantly Increasing Competition
We are seeing a competitive race to the bottom as developers of energy assets increase participation in global auctions and tenders to originate new renewable energy assets while dealing with continued downward pressure on supply costing almost a quarter less than 2015 levels. Asset managers then deal with intense competition purchasing such assets with already compressed economics.
- Decreasing Profit Margins
With the aforementioned reduction in power prices and increasing competition, profit margins for energy asset managers have waned. PricewaterhouseCoopers estimates that since 2015, profit margins for asset managers of energy assets have declined 10 percent globally. As these they feel this squeeze, asset managers also feel further pressure from their investors who have increasing expectations regarding data transparency and performance visibility.
Together, these factors have made many investors more risk-averse in their investments, and for good reason: energy asset managers are having difficulty earning investor confidence because they have been unable to consistently meet or exceed forecasted returns.
Mercatus, a global leader in delivering investment and asset management solutions across over $400 billion of assets in over 100 countries, has seen such challenges play out over the last 5 years. For example, from 2015 to 2017 we observed that project returns dropped on average 250 basis points (bps) over the investment decisioning lifecycle from when a project was first approved for investment to when a project had completed its first year in operation. Furthermore, in certain more competitive regions, we have we seen as much as a 400 bps drop when more aggressive assumptions ended up not delivering against expectations. To put this in perspective, for a $1 billion fund, a 250-400 bps drop across a portfolio could represent between $25-40 million in lost profits due to the leakage of profits occurring across the investment lifecycle.
We call this drop in returns IRR Deal Leakage or the over-estimation of an asset’s ultimate Internal Rate of Return (IRR). We started tracking this performance indicator in Mercatus five years ago, and have found IRR Deal Leakage to exist across the energy and power industry independent of asset classes, from energy generation to storage technologies.
Where is the Leakage Occurring?
Looking across over 10,000 assets across 210 gigawatts of energy and power assets managed in Mercatus, the key drivers of IRR Deal Leakage stem from the inaccurate estimation and forecasting of four key project assumptions: the cost of operations and maintenance (O&M), the cost of energy (off-take), estimation of production, and estimation of capital expenditures (CapEx).
As shown in the above table, off-take rates, in particular, are the highest and most commonly over-estimated values, as forecasts have predicted them to be on average 9% higher at project inception than the actual value at the end of the first year of the asset’s operation. These mistakes in the investment lifecycle can be devastating to project IRRs and must be more closely monitored and managed to prevent such wide variances of Leakage.
A Root Cause of Diminishing Returns
As we speak to finance executives across the energy sector, we have invariably found that IRR Deal Leakage is one of the most pervasive issues impacting profitability, and one that few have been able to solve. We have also found that a good first step in helping such executives find solutions is to help them consider why their IRR forecasts are so inaccurate. Our diagnostic process has consistently shown that the answer lies in how most investment organizations manage and utilize data, especially data used in conjunction with making investment decisions.
Questions we commonly ask executives investing in and managing energy assets are:
- How many data sources today are required to make an investment decision?
- How many departments are required to contribute to such data and are they all working from one source of truth?
- How certain are you that you are making decisions on the most accurate data at the time of your decision?
- How well are you performing against the key project assumptions that you forecasted during the investment lifecycle? How often are you comparing this?
Most executives agree that the answers to these questions depend on the state of data management in their organizations. There is little to no centralization of critical data points like project assumptions and financial models, and there are many sources for the same information commonly stored and managed across multiple departments. To make informed investment decisions, organizations must reconcile these data sources to perform the above analyses, which often takes many days or even weeks.
Why is this the case? Because most leverage spreadsheets as their source of truth for project information and assumptions. These “databooks” are rarely stored in a single location—often times, they are distributed across emails, desktops, and sharing applications.
Additionally, finance teams leverage this scattered information within investment models, which also exist in spreadsheets that are not centrally located or controlled. In fact, for a single investment decision, most organizations average 80-100 iterations of these databooks and corresponding financial models with hundreds of changes in project assumptions across a project’s lifespan. As a result, most finance teams are simply overwhelmed sifting through the massive amount of data from disparate spreadsheets and other inconsistent data sources. Many organizations end up with little ability to extract data for insights like those illustrated above to help inform and minimize risk on investment decisions.Thus, executives are left with few to no leading indicators when investments are not performing to expectations or are at risk.
The Digitalization Opportunity
Asset managers with an energy portfolio that intend to survive and thrive in today’s highly competitive, performance-driven market should carefully examine their data management strategies. To take full advantage of the opportunity, most firms will have to make a cultural shift in how they think about data. No longer should it be acceptable to have disconnected, siloed, and poorly networked data, in spreadsheets or otherwise. By taking the issue head on, asset managers can transform their organizations to improve profits and prevent IRR Leakage. As shown, a $1 billion fund alone could see $25M-$40 million in lost profits. If that same fund could capture just 15-20% of these lost profits, the organization can easily take back $4-8 million in profit, which should be welcome news to any energy asset managers. `
Or, asset managers can continue business as usual and leave that money on the table.
